The Three Fund Portfolio

[corn18]

in to follow

 

[Doc0]

I would offer that "risk" is a useful word with a well understood meaning. Using the word "risk" in lieu of the term "square toot of variance" muddles the issue, it doesn't clarify it.

A retiree can, today, purchase a portfolio 100% of 30 year Treasuries with a fixed yield of 2.6%. He may be told by his FA that his portfolio is risk free, since it has no repayment risk and zero variance in rate of return (heck, if the rate were -10%, it would still be risk free). Now, in the way most people understand the word "risk" in their daily lives, is the real (i.e. inflation-adjusted) value of our retiree's portfolio truly at zero risk over the next 3 decades? Is its real return free of variability, variance, and fluctuation?

Using correct term ("square root of variance in annual return") improves the situation, IMO.

You choose the case of a virtually risk-less portfolio. This assumes your life is not leveraged and only needs to make inflation to stay alive. Bernstein suggests TIPS. Most people have stock in their portfolio to augment the need to pay for the leverage. The way you augment that is to purchase risk assets. You need a metric to judge relative performance of a portfolio and the efficient frontier plane is just such a metric. You don't want to use it, not my problem.

 

[OldShooter]

@samclem, @Doc0, you are both implicitly buying the idea that volatility is risk and vice-versa. That may have been useful to Markowitz because volatility can be measured and risk is not so easy. But for real-world investors I think this is a false premise. Montgomery Ward, Sears Holdings, GE, Enron, Theranos, PG&E, ... The list goes on and on.

I'm pretty sure, for example, that it would be possible to design a portfolio on the efficient frontier that has much higher risk than its volatility would imply. Utility stocks, as we gaze into a renewable future, might be a good place to start.

Playing around with standard deviations makes the situation even worse because the real-world price distributions are nowhere near Gaussian in shape, are not symmetric, and, importantly, the samples are not independent. If they were independent, no one would be able to talk about momentum.

 

[2177V]

Pop Quiz:
An Investor has a 50/50 portfolio which a crash then occur which the stocks value decline 50% while the bonds maintain it's value before the crash. The investor's portfolio has now changed to 33% stock/67% bond.

I suggest two possible options in this situation for that investor:

Option 1: Do nothing and let the market recover which will change his portfolio back to 50/50.
Option 2: Re-allocate his 33/67 portfolio back to 50/50. This will take advantage of the recovery, possibly beat the market in the long run, but may involve taking a higher risk than Option 1.

IMO this is no right answer because everyone's risk tolerance is different.

I do not believe in stock picking because the risk is too high for my own risk tolerance. When I was young, I believed in actively managing my portfolio to suit my risk tolerance, my financial situation/goals and the market conditions. One strategy for one does not apply to another.

One of the reason why I present this pop quiz is that some people (but not all) believe our current 9 year bull run will last forever. The person who has a 100% treasury bond portfolio is not wrong....if that portfolio is compatible with his or her own risk tolerance, his or her financial situation/goals and he or she also believe that the 9 year bull run is not going to last forever. There is nothing wrong having a portfolio designed for capital preservation. "Capital preservation" and "getting the market returns" are two different goals.

Food for thought.

 

[redduck]

That may have been useful to Markowitz because volatility can be measured and risk is not so easy. But for real-world investors I think this is a false premise. Montgomery Ward, Sears Holdings, GE, Enron, Theranos, PG&E, ... The list goes on and on.

Talk about a bad-luck, dart-throwing monkey hitting Montgomery Ward, Sears Holdings, GE, Enron and Theranos. But on the upside I can envision a reality show entitled "Markowitz Meets the Monkey."

 

[samclem]

@samclem, @Doc0, you are both implicitly buying the idea that volatility is risk and vice-versa.

If I've left that impression then I haven't communicated well. I have no objection to MVO, or to making groovy charts showing the efficient frontier, etc. My gripe is with the use the term "risk" to label the X-axis on those charts (and, more broadly, to use "risky" rather than "volatile" to describe individual equities or entire portfolios that have high variability of either returns or value).
A retiree with a 40 year withdrawal horizon can easily withstand considerable ups and downs in short term portfolio values. If the long-term (smoothed), real value of their portfolio remains on an upward trajectory they may have little to worry about and be at low risk, especially compared to a less volatile portfolio that nonetheless loses real value over time (due to withdrawals, returns, or any other reason).

 

[Janet from FIRE Planet]

Why you might not want to invest in International Funds

After reading the two articles below & other articles as well, I no longer invest in International Funds. I do not think International Funds should be a part of a Three Fund Portfolio approach for investing for retirement. If you want International fund exposure, I think it should be a very small part of a portfolio.



https://www.usatoday.com/story/money/2015/01/16/investing-international-funds/21825245/

https://www.themoneyhabit.org/shoul...stocks-in-your-portfolio-a-data-based-answer/

 

[NW-Bound]

Ah, come on: you're basing your argument on one study that took place in Yugoslavia (circa 1951) and has never (at least to my knowledge) been replicated. As a side note, about 1200 the monkeys did not complete the experiment as they were asked to leave due to their disruptive behaviors. Furthermore, the researchers' judgment was called into question regarding trying to place 10,000 monkeys in a stadium with a capacity of 4300.

Good question, aja8888. But, it's not a matter of what I believe. Let's talk science here.


FYIO, aja8888..

The monkeys involved in the research were vetted. Monkeys that could tell heads from tails were excluded. No need to additionally contaminate a pre-doomed research project. How this ever got funded remains a mystery to me. But, that's besides the point and we don't want to go off on a tangent.

However, since you show an an unusual amount of interest in this research let me share some more little-known information about this project:

There were a number of events during the trial that were not anticipated.

1. Monkeys chose to bite into the coins before trying to flip them. Most of the monkeys after biting into the coins seemed disappointed or angry and simply threw the coins away. Some of the coins hit other monkeys which caused angry posturing and occasional hitting.

2. Another problem arose when some of the male monkeys gathered the thrown coins (before the researchers could get to them) and offered female monkeys the coins (for what reason I do not know). However, if a female monkey declined accept the coins, a whole lot of screeching occurred, causing the researchers to weep.

3. The monkeys did not understand the concept of bathroom breaks (causing the researchers to retch).

4. The monkeys, early on in the experiment, divided on philosophical grounds, into two camps. Even though they couldn’t tell heads from tails, let alone flip a coin, the two groups become extremely agitated with one another about the meaning of having a coin land on the same side twice in-a-row. Was it luck or was it skill?

aja8888, thanks for asking me something that I know about.

You've got me to realize that there's so much I do not know about using monkeys to conduct experiments.

It's not as simple as it seems, to motivate monkeys to throw coins. Many are just too lazy.

 

[OldShooter]

If I've left that impression then I haven't communicated well. ... My gripe is with the use the term "risk" to label the X-axis on those charts (and, more broadly, to use "risky" rather than "volatile" to describe individual equities or entire portfolios that have high variability of either returns or value).
A retiree with a 40 year withdrawal horizon can easily withstand considerable ups and downs in short term portfolio values. If the long-term (smoothed), real value of their portfolio remains on an upward trajectory they may have little to worry about and be at low risk, especially compared to a less volatile portfolio that nonetheless loses real value over time (due to withdrawals, returns, or any other reason).

OK, sorry. I did misunderstand. We agree, I think.

I can buy an argument that volatility can be a risk for a portfolio where equities much be sold regardless of market conditions -- sequence of returns risk, for example. But there is much more about risk that is not captured by measuring volatility and, hence, not captured by the concept of finding an efficient frontier or by playing around with variance numbers like SD, Sharpe ratio, Sortino ratio, etc.

 

[ERD50]

Pop Quiz: ....

One of the reason why I present this pop quiz is that some people (but not all) believe our current 9 year bull run will last forever. ....

No doubt at least one person on the planet believes this. But I honestly do not think I have heard a single person on this forum express that belief. You seem to think some pretty significant % of us do believe that, your only exclusion being "not all".

Maybe you need to clarify that before we go too deep? It comes across as a possible straw-man.

Pop Quiz:
An Investor has a 50/50 portfolio which a crash then occur which the stocks value decline 50% while the bonds maintain it's value before the crash. The investor's portfolio has now changed to 33% stock/67% bond.

I suggest two possible options in this situation for that investor:

Option 1: Do nothing and let the market recover which will change his portfolio back to 50/50.
Option 2: Re-allocate his 33/67 portfolio back to 50/50. This will take advantage of the recovery, possibly beat the market in the long run, but may involve taking a higher risk than Option 1.

....

Food for thought.

You've just described "re-balancing", a well known, and often followed approach here. The studies I've seen are rather blah about it - it helps in some cases, but also has you selling on the way up in a long bull market, leaving gains behind, pretty much a wash. I've decided to not worry much about it, but some feel more comfortable with a set AA, which is fine.

-ERD50

 

[2177V]

Here is a link the LEI which currently indicates an upward trend. This implies the US economy is in good shape as of May 20 2019. The LEI is published every month.

https://www.conference-board.org/pdf_free/press/US LEI - Press Release MAY 2019.pdf

However, if you look at the historical LEI BEFORE the last two recessions in the above link, the LEI was trending downward.

Should investors re-allocate their portfolio to become more defensive.....when there is a downward trend in the LEI?

I intend to re-allocate when there is a downward trend....but other people may choose to ignore it.

Life is all about choices.

 

[redduck]

Life is all about choices.

Damn! You should have announced "SPOILER ALERT" at the beginning of your post!!!

 

[ERD50]

...
Should investors re-allocate their portfolio to become more defensive.....when there is a downward trend in the LEI? . ...

IMO, no. I think investors should just B&H, I haven't seen evidence that says any indicator is reliable enough to drive my investment decision.

...
Should investors re-allocate their portfolio to become more defensive.....when there is a downward trend in the LEI?

I intend to re-allocate when there is a downward trend....but other people may choose to ignore it. ...

Can you provide more evidence that there is a strong correlation? A couple observations may be no more than coincidence.

Spurious Correlations (many more examples here)


-ERD50

 

[2177V]

IMO, no. I think investors should just B&H, I haven't seen evidence that says any indicator is reliable enough to drive my investment decision.




Can you provide more evidence that there is a strong correlation? A couple observations may be no more than coincidence.

Spurious Correlations (many more examples here)


-ERD50

Here is a link on LEI:
https://www.investopedia.com/articles/economics/08/leading-economic-indicators.asp

Note that this link stated the following:

"Leading economic indicators can give investors a sense of where the economy is headed in the future, paving the way for an investment strategy that will fit future market conditions"

I made a personal decision to adopt the LEI as part of my investment strategy. However, that does not mean everyone should do the same....since a personal decision is a personal decision.

I am stating that B&H is the best strategy to have in the long term. I adopted B&H in 90% of my portfolio. The remaining 10% was active trading. I made some money in the health sector because the health sector was ripping off the American public and they made contributions to politicians to protect their business model.

I am now in the process of reducing my IRA and increasing the number of properties that I have...due to estate planning reasons. An inherited IRA is taxed as ordinary income for my beneficiaries during withdrawals while inherited property is treated differently. This means I getting out of the growth phase for my IRA and "in the long term" does not apply to me.

I am now slowly transferring my stock assets into ST treasury and ST corp bonds in my IRA and cashing out extra IRA assets and paying the CG taxes now so my survivors will not be stuck with a tax burden. Significant changes in the LEI will only accelerate this process because I cannot accept the risk that the LEI correlation is NOT a coincidence.